Understanding Qualified Settlement Funds, Taxation, and Tax Reporting

Qualified Settlement Funds (QSFs) have increasingly become pivotal in resolving lawsuits, particularly for personal injury, wrongful death, and property damage claims. QSFs provide a tax-efficient vehicle for the settlement of claims, facilitating smoother and more efficient resolutions. However, the taxation rules surrounding 26 USC § 468B settlement funds are complex, and understanding them is vital for practical usage. This guide sheds light on the pertinent aspects of taxation and the associated reporting and underscores the importance of seeking professional advice for complex issues. Failure to adhere to these reporting requirements can lead to penalties and legal consequences. This reassurance of support from experts in the field can be a valuable resource in your professional role.

Introduction to QSFs

26 C.F.R § 1.468B-1 Qualified Settlement Funds have emerged as an essential instrument for resolving various types of claims in legal settlements. Established under § 1.468B-1 et seq. of the Internal Revenue Code, settlement funds manage the proceeds from a legal settlement (or judicial award) and offer substantial benefits to both plaintiffs and defendants. These benefits include tax deferral opportunities and the ability to structure payments over time, empowering the parties with more control over their financial arrangements and providing a sense of reassurance.

Treated as a Corporation

Except as provided for in § 1.468B-5(b), a QSF is considered a corporation for tax treatment purposes. Understanding this tax treatment is crucial as it will equip you with the knowledge to navigate the associated taxation.

Modified Gross Income

A QSF is taxed on its “modified gross income.” The term modified gross income generally comprises only the investment income generated. Moreover, settlement payment amounts transferred to a QSF to resolve or satisfy a liability for which the fund is established are excluded from the trust's modified gross income.

A deduction against modified gross income is allowed for QSF administration and other incidental costs and expenses incurred in administering the QSF. Deductible expenses may include administrative costs, such as accounting, legal, and other ministerial expenses, as well as state and local taxes. Also, the costs associated with the determination and notification of claimants and claims administration are deductible.

Note: Administrative costs and other miscellaneous expenses do not include legal fees incurred by or on behalf of claimants and are thus not deductible.

The Emergence of Form 1120-SF

IRS Form 1120-SF is a crucial component in the taxation process of a § 468B trust. It reports the transfers, income generated, deductions claimed, and distributions made. More importantly, it calculates and reports the associated income tax liability. Understanding and confidently navigating the process of filing Form 1120-SF is essential in the QSF taxation process.

Filing Due Date

The QSF administrator plays a key role in filing the tax return. They are responsible for preparing and filing the income tax return Form 1120-SF by the 15th day of the 4th month following the end of the fund's tax year. The administrator's responsibilities include ensuring all necessary forms and schedules are included, making timely tax deposits, and arranging for the fund's tax professional, financial institution, payroll service, or other trusted third party to make the deposits. It's important to note that there are exceptions for funds with a fiscal tax year ending on June 30 and those with a short tax year ending in June, in which case the filing deadline is earlier.

Private Delivery Services (PDSs) can meet the “timely mailing as timely filing/paying” rule for tax returns and payments. However, it’s essential to note that PDSs cannot deliver items to P.O. boxes, necessitating the use of the U.S. Postal Service for such deliveries.

Signature Requirements

The return must be signed and dated by the fund’s trustee or administrator. If an employee completes Form 1120-SF, the paid preparer’s space should remain empty. Anyone who prepares the form but doesn’t charge for the filing should not complete that section.

Note: A paid preparer may sign original or amended returns using a rubber stamp, mechanical device, or computer software.

The preparer must complete the required preparer information, sign the return in the designated space, and provide a copy of the return to the trustee or administrator.

Paid Preparer Authorization

If a fund trustee wishes to permit the IRS to discuss its tax return with the paid preparer, it can check the “Yes” box in the signature area of the return. This authorization applies only to the individual whose signature appears in the “Paid Preparer Use Only” section of the tax return and does not apply to the firm.

The authorization allows the IRS to contact the paid preparer to answer any questions that may arise during the processing of the return, provide any missing information from the return, get information about the processing status of the return, and respond to IRS notices about errors, offsets, and return preparation.

This authorization, however, does not allow the paid preparer to receive any refund check, bind the trust to anything, or otherwise represent the fund before the IRS. The authorization automatically ends on the due date (excluding extensions) for filing the QSF’s tax return.

Assembling the Return

To ensure correct processing, include all schedules alphabetically and other forms in numerical order after Form 1120-SF. If the return requires more space for forms or schedules, separate sheets are allowable if the pages are the same size and format as the printed forms.

Where and How to File

The Form 1120-SF return should be filed at the applicable IRS address, which (as of this writing) is as follows:

Department of the Treasury
InternalRevenue Service Center
Ogden, UT 84201-0012

Tax Payment Obligations

The taxes are due and payable in full by the 15th day of the 4th month after the end of the tax year.

QSFs must use electronic funds transfers to make all federal tax deposits. These transfers are payable using the Electronic Federal Tax Payment System (EFTPS). However, the settlement fund can also arrange for a tax professional, financial institution, payroll service, or other trusted third party to make the deposits.

Estimated Tax Payments

Generally, a QSF must make installments of estimated tax if it expects its total tax for the year (less applicable credits) to be $500 or more. The installments are due by the 15th day of the tax year’s 4th, 6th, 9th, and 12th months.

Note: If the fund overpaid estimated tax, it may file Form 4466, Corporation Application for Quick Refund of Overpayment of Estimated Tax.

Interest and Penalties

Interest accrues on taxes paid late, even if there is an extension of time to file. Penalties can also be imposed for negligence, substantial understatement of tax, reportable transaction understatements, and fraud.

Accounting Method

A Qualified Settlement Fund must use the accrual method of accounting. The accrual method records income and expenses when earned or incurred, regardless of when payment is received or made.

Recordkeeping

Keeping accurate and detailed tax and accounting records is essential. These records support income, deductions, or credits on the return.

Definitions

In the context of § 1.468B-1, specific terms are of particular importance:

• Administrator: The person who manages the QSF, which can include a trustee if the settlement fund is a trust.
• Transferor: A person who transfers money or property to a QSF to resolve or satisfy claims against that person.
• Related person: Any person who is related to the transferor as defined in section 267(b) or section 707(b)(1) of the IRS code.

Conclusion

Understanding the taxation of Qualified Settlement Funds established under 26 C.F.R § 1.468B-1 et seq., s can be complex.

However, platforms such as QSF 360, provided by Eastern Point Trust Company, offer the only online and turnkey service that includes all of the critical aspects of tax reporting, such as Form 1120-SF, filing requirements, and tax payments. As always, seeking professional advice when dealing with complex matters is advisable.